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Re-Thinking Economics Part 3

Almayer and Brooks

Let us imagine two city-states, Almayer and Brooks. Almayer’s economy is run on Credit-ism principles while Brooks economy are run on Shariah-based principle. Both have entrepreneurs and merchants that need to be financed. Almayer finance them using interest-bearing loans while Brooks opt for investment via Mudharabah & Musharakah.

Almayer creditors loaned $3000 at 10% interest rate and Brooks investors financed $3000 in return of 1/3 profit share. Assuming that both Almayer & Brooks trader made a profit in their expedition to Calvin as expected, say $900. Then the interest payment will be $300 to Almayer creditors and profit of $300 to Brooks investors.

Numerically, it looks similar as both the creditor and investor gained $300. Both traders now have $600 each in their account.

But this is when everything turns out as expected — normal profit one might say. But how does Almayer and Brooks fare during upsides and downturns?

Upside

Now we go for a second round of loan and financing of the same amount of $3000. The difference this time is that the goods sold by both Almayer and Brooks traders are in high demand. Thus they make higher profit of $1200.

Almayer creditors will just gain $300 in interest payment while Brooks investors will gain $400 profit. Almayer trader now have accumulated $1500 while the Brooks trader now have $1400. So what if the Islamic investors gained a bit more during upside? Still not much of a difference and the trader can’t retain maximum profit.

But they are not the same. Usury is not the same as profit. Interest-bearing loan are a different animal as compared to profit-sharing ventures.

Loan contracts alienates people, it squarely assigns people as debtor and creditor. A deal is a deal, whatever happened the debtor must pay the creditor the principal amount plus interest. The creditor doesn’t care what the debtor does as longs as he gets paid on time.

Even more perversely, the creditor stands to gain if the debtor can’t service his debt on time as the interest payment will increase. In short, the contract puts them on opposing sides.

On the other hand, Mudharabah & Musharakah agreements puts the investor and the entrepreneur on the same side. They became one team that have stake on the stewardship of the capital in order to generate profit. It is easy to imagine the investor coaching and passing down wisdom to the entrepreneur in order to protect his investment.

Downturn: Round 1

However, we can see how loan and investment diverged when the market starts to face downturn. This time, both Almayer and Brooks trader only make profit of $600 each as Calvin citizen faces poor harvest.

As the Almayer trader have some other obligations that require him to use the profit first he paid back his loan a bit later. His interest payment goes up to $330 instead of $300. The Almayer creditor just get his money later than usual but gained through higher interest payment.

Meanwhile the Brooks investors just get $200 instead of $300. But the Brooks trader is not under pressure to fork out more either. He can freely use his portion of profit.

The account balance of Almayer and Brooks traders begin to diverge. Almayer trader now only have $1870 ($370 + $1500) while Brooks trader have $2000 ($400 + $1600) to his name. Almayer creditors have anti-fragility at the expense of Almayer trader fragility.

But what happened afterward further illustrates the difference between loan and investment. For the Almayer creditor, it is still business as usual. His principal capital is protected so he lend out the same amount again.

Brooks investor had taken a hit and experienced pain. So they reduced their exposure to the market and invested only $2000 instead of $3000.

Downturn: Round 2

The market goes south a bit more. Both Almayer and Brooks traders barely manage to sell off all their goods. They had to give heavy discounts and end up with loss at the rate of 5%. The Almayer trader lost $150 and the Brooks trader lost $100.

At this point the difference really bites. Almayer trader have to claw earlier profits to pay the creditors. Their account balance is now only $1420 ($1870 — $150 — $300).

Brooks investors took a hit of $23 while the trader lost $67. So now their account balance is $1933 ($2000 — $67). The difference is $513, almost similar to their profit during normal times.

And Multiply All This Systemwide

Of course, this is just two traders with their respective creditor and investor. The same drama and dynamics must have taken place in various permutations several times over in each city.

In Almayer, the losses compounds as the downturn gets worse. More debtors are late in their payments and some started to default. This in turn made the creditors themselves in trouble with their own creditor. They had to fork out money to keep up with interest payment.

The chain reaction doesn’t stop there because even the second-level creditor have their own higher level creditor. Loss quickly snowballed and before long money had dried up from Almayer capital market and the apex creditor went bust. This is despite we didn’t introduce Fractional Reserve Banking system into Almayer economy yet. If not, the losses had been exponential.

Back in Brooks, things are a different. As they had experienced pain earlier, some investors had stopped investing. Those who continue to invest experience losses but it is ditributed justly among the players. The loss also didn’t have second-order effect since the investors capital doesn’t (and can’t ) come from loan. As a result, aggregate capital is still intact in Brooks and they can quickly regain profit once the market went up again.

To the Almayer people, market simply suddenly collapse. The city of Brooks however had been more attuned to the fluctuations and adjusted their exposure accordingly. Thus they perceive gradual decline in profit rather than a sudden one.

Legalizing commercial loan in Almayer did gave them short term boost as more capital are made available. However, taking loans upon loan upon loan had made Almayer financial system tightly coupled. In the short term Brooks have less money but in the long term their loosely coupled system can effectively retain more of that money.

But this is just business, how does Islamic acts of worship made the Brooks investors and traders better economic players?